Pension scheme deficits can undermine any business, no matter how well it's run.
So you're just about to buy some shares. You've had a good look through the company's accounts and are reasonably happy about the balance sheet. But wait a minute; are you aware that a potential timebomb lurks in many companies' accounts?
This timebomb is the company's final salary pension scheme. That's right; the boring old pension scheme has mutated into a financial weapon of mass destruction.
The problem for many companies is that the stock market falls over the last decade have resulted in the company being relatively small in comparison to its pension scheme. The effect is that small fluctuations in value of the scheme's assets now have a major effect upon the firm's profitability. For example, British Airways (LSE: BAY) current market capitalisation is a mere £1.7 billion whereas its pension scheme assets in its 2008 annual report were £6.7 billion, almost four times this figure. Furthermore BA recently estimated that its scheme deficit (liabilities minus assets) was approximately £2.9 billion.
The problem for many companies is that the combination of poor stock market returns, Gordon Brown's April 1997 raid on pension schemes and the increasing life expectancy of scheme members have turned their pension schemes into giant millstones around their corporate necks.
The big lie
Company-sponsored final salary pension schemes used to be boring beasts attended to by actuaries (the profession for those who find that accountancy is too exciting). The scheme's assets (shares, cash, gilts and property) and its liabilities (current and future pensions) would be valued every three years using a discounted cashflow method rather than using market valuations. The effect of this was to smooth out the wilder stock market movements and thus the pension scheme's impact upon the profit and loss account was relatively minor.
The problem started in 1997 when the incoming Labour government started to tax pension schemes' dividend income, claiming that this would have no effect upon their financial position. I suspect they were taking heed of Herman Goering's statement that "no matter how big the lie; repeat it often enough and the masses will regard it as the truth."
Many schemes dealt with the tax grab by using a bit of actuarial trickery. If they changed their assumptions for future investment returns they could easily cancel the short-term effects of the new laws. The big problem was that if the new assumptions turned out to be overoptimistic then the scheme's funding position would become even worse. Furthermore, schemes were being hampered by those financial "experts" at the Treasury who had imposed excessively strict rules concerning surplus pension scheme assets that meant that schemes with good surpluses had to run these down via "contribution holidays" so that there was no "fat" remaining when global stock markets went into freefall in 2008.
A pension scheme that masquerades as a business
Pension schemes nowadays value their assets using market prices. This means that stock market falls (and rises) are now directly reflected in the profit and loss account. Thus for many companies the performance of the stock market has a far greater effect upon its profitability than the business. It is more accurate to treat many companies today as being a pension scheme which also happens to operate a completely unrelated business.
British Airways, as mentioned above, is a good example of this. Malcolm Wheatley recently wrote about BT Group (LSE: BT-A), whose pension scheme deficit significantly contributed to its dividend being cut by almost 60%.
Indeed, in its latest report, BT appeared to be more interested in talking about the scheme's "platinum ranking" and its current policy of moving its scheme towards more ethical investments. This attitude reminds me of the story about the hiker in the mountains who carries a gun to protect himself from bears. On seeing that he is going to be mauled by a grizzly, the hiker refuses to shoot because he is worried about the environmental damage caused by lead bullets!
For companies like BT the scheme deficit is the problem; tinkering around the fringes of investment policy is merely putting a tiny plaster over a massive sucking chest wound.
How to defuse the bomb
Most companies have taken some action to deal with this problem; the vast majority of private sector pension schemes are now closed to new entrants. This is in contrast to index-linked public sector schemes which are still generously funded by the taxpayer. Although the public sector has even greater problems with its pension scheme funding, the state can always resort to taxing the rest of us. The Economist magazine recently contrasted the difference between private and public sector pension schemes as being "pensions apartheid".
Of course, if (and that's a really big if) the stock market rises sharply in the near term, pension scheme deficits will shrink and possibly disappear. In anticipation of this happy event companies with a very large pension scheme could turn out to be a good investment. However, this strategy could become a complete disaster; in extreme cases if the deficit becomes too large the company might even be swallowed up by the pension scheme.
If investment returns remain poor for the next few years, companies will have to put more money into their pension schemes, meaning lower profits and dividends, and/or cut scheme members' benefits, which is quite difficult to do. Personally I think that it's only a matter of time before every major private sector employer follows the example of Barclays (LSE: BARC), which two weeks ago closed its pension scheme to all of its employees.
For those of you who've got this far, to cheer you up here's something else to think about! Many companies have another timebomb in their accounts -- innocuously named "contingent liabilities". These are items such as guarantees on assets which the firm has already sold and in many cases they make the pension scheme deficit seem trivial. I plan to look at these in a future article.
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